Cooperative may charge patronage capital loss to members

Plain-English summary

A nonexempt Subchapter T cooperative received stock through a patronage-related arrangement to develop an online purchasing platform for its members. It treated the stock's receipt and vesting as patronage income and issued a special class of written notices of allocation designed to absorb a later capital loss. After the successor platform company was sold and the cooperative realized a capital loss, it proposed redeeming part of the notices and reducing the remaining notices pro rata. The IRS ruled that the loss could be charged to the members holding the special qualified notices and that canceling the notices would have no tax effect to the cooperative other than reducing its tax loss from the sale.

Ruling snapshot

• Question: Could the cooperative charge the patronage-related capital loss to members by canceling special written notices of allocation?
• Outcome: Approved
• Key authorities: Treas. Reg. § 1.1382-3(c)(3); Rev. Rul. 69-67; Rev. Rul. 70-407; Rev. Rul. 81-103

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201529004 Third Party Communication: None
Release Date: 7/17/2015 Date of Communication: Not Applicable
Index Number: 1381.00-00
Person To Contact:
----------------------- ----------------------------, ID No. -----------
----------------------------------- Telephone Number:
-------------------------------------------------- ----------------------
--------------------------------- Refer Reply To:
----------------------------- CC:PSI:B05
PLR-136963-14
Date:
March 27, 2015

LEGEND:

Taxpayer = ------------------------------------------------------

Corp 1 = --------------

Corp 2 = ---------------------

LLC 1 = -------------------

LLC 2 = -----------------------------------------------

Dear --------------

This is in response to a letter dated September 30, 2014, submitted by your
authorized representative regarding a planned method for handling a loss realized by
Taxpayer.

Taxpayer is a nonexempt Subchapter T cooperative. As a consequence,
Taxpayer files its federal income tax return on Form 1120-C (U.S. Income Tax Return
for Cooperative Associations). It does so on the basis of a calendar year. Taxpayer’s
overall method of accounting for federal income tax purposes is the accrual basis.

Taxpayer is a cooperative serving the nation’s leading ------------------------------
centers and their affiliate---------------. Taxpayer offers members a variety of products
and services to help members measure and improve -----------, operational, and financial
performance. Currently, Taxpayer has as members approximately ---------------------------
------------ centers and ----- affiliate --------------.

PLR-136963-14 2

Taxpayer’s members use a broad range of products and services in the day to
day operation of their ---------------------------centers. One of Taxpayer’s core functions is
what it describes as “supply chain optimization.” Focusing on the unique needs of -------
---------------------------centers, Taxpayer provides a comprehensive array of services to
help members reduce total supply cost and improve their overall supply chain
performance while remaining focused on quality.

As part of supply chain optimization, Taxpayer provides its members with access
to contracts with a wide variety of vendors (both suppliers and distributors). The
contracts cover most of the products and services that a ------------ or other -----------------

------------- uses in the course of serving its ------------. Taxpayer members place orders
under the contracts directly with the vendors. The vendors ship the products directly to
the members. The vendors bill Taxpayer members directly, and Taxpayer members pay
vendors directly.

Before -------, Taxpayer negotiated and managed the portfolio of contracts itself.
In -------, Taxpayer agreed with Corp 1, another group purchasing organization serving -
-------------- and ------------------organizations, to combine their contract negotiation and
management functions. They did so to enhance their bargaining power with vendors,
eliminate duplication, achieve other cost savings and generally expand and improve the
portfolio of contracts they could offer to patrons. They formed a joint venture known as
LLC 1 which now handles the contract negotiation and management functions for
Taxpayer and Corp 1.

Today LLC 1 considers that it has --------------------------------------------------------------

------------------------------------------------------------------------------------------------- LLC 1’s
contracts --------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

------------ During ------- Taxpayer members purchased approximately ---------------of
products and services through LLC 1.

In choosing vendors for particular products, LLC 1 looks for suppliers that provide
the best-quality products and demonstrate broad-based ----------- acceptability at the
optimal total value for members. The contracts negotiated by LLC 1 typically provide
lower prices and better terms than patrons could find elsewhere. They also typically
provide for a payment from vendors (referred to as a “marketing fee” or an
“administrative fee”) related to the volume of purchases under the contract. The

PLR-136963-14 3

administrative fees related to purchases by Taxpayer patrons under the LLC 1 contracts
are collected by LLC 1 and remitted to Taxpayer. They are, in turn, used to cover
Taxpayer’s group purchasing operating expenses (including its share of LLC 1 costs),
and any excess is distributed by Taxpayer to members and other participating patrons
in the form of a patronage dividend. Taxpayer’s patronage dividends for ------- related to
supply chain management activities totaled approximately $----------------.

During -----------------, Taxpayer sold its --------interest in a limited liability
company, known as LLC 2, to a private equity investment firm. Taxpayer’s sale of its
interest was part of a negotiated sale of LLC 2 by all its owners. Taxpayer received a
cash payment of $---------------for its interest. For tax purposes, Taxpayer realized a loss
of approximately $-----------------, all of which Taxpayer anticipates will be capital in
nature. For patronage purposes, Taxpayer has consistently regarded the activities that
culminated in the sale of its interest in LLC 2 to be patronage in nature, and it regards
the loss it realized as a patronage loss.

This ruling request relates to Taxpayer’s plan for handling the proceeds and loss
resulting from the sale of its interest in LLC 2 for patronage accounting purposes.

Taxpayer’s supply chain optimization activities, and in particular its contracting
activities, are described above. Once contracts are negotiated, members deal directly
with vendors in placing orders, shipping, billing and payment for the products covered
by the contracts. Historically, members placed orders with vendors using a variety of
different channels of communication – mail, private courier service, telephone, fax, or
electronic data interchange.

In the late 1990s, use of the internet for business purposes was still in its infancy.
Many thought that the internet would allow for the development of business-to-business
exchanges which would permit customers to deal directly with vendors and thus would
change how many products, including products used by ---------------and ----------------- ---
---------------, were purchased and sold. No exchanges of this sort existed at the time in
the ---------------- industry. The major companies involved in the industry, group
purchasing companies representing -------------- and large -----------------suppliers and
distributors, realized that they would likely need to play a leading role if such sites were
to be developed.

Several companies were formed with the objective of constructing exchanges
and then attracting companies to use their exchanges. ----------------------------. (later
known simply as Corp 2) was one such company. It went public in --------------------,
raising approximately $-------------- to be used to develop an exchange. At the same
time, some of the large suppliers and distributors of ------------ supplies decided to pool
their resources and build an exchange. In ---------------of the world’s largest --------------
product manufacturers formed LLC 2 for just this purpose.

PLR-136963-14 4

Corp 1, Taxpayer, and LLC 1 considered their options. They believed that
potential benefits for ------------ members would be substantial if an exchange could be
developed. Such an exchange promised to significantly improve supply chain
optimization, one of their core missions on behalf of their members. As a result, they
wanted to be in the forefront of any developments. They considered building their own
exchange, but ultimately decided to join forces with Corp 2 to develop a web site to
serve as a portal for Corp 1 and Taxpayer patrons to place orders with vendors for
products purchased under the LLC 1 contracts.

The business relationship made sense for both sides. Corp 2 was in the process
of developing an exchange, and brought development expertise to the table. However,
Corp 2 was developing an exchange in the hope that it would be able to attract
suppliers, distributors and ------------- to the site and that they would be willing to pay to
use it. Corp 1, Taxpayer and LLC 1 had the capacity to bring users (i.e., their members)
to the website.

Corp 2 agreed to develop a website in accordance with Corp 1, Taxpayer and
LLC 1 ’s specifications and for the exclusive use of Taxpayer, Corp 1 and LLC 1 . Corp
1 and Taxpayer agreed to make substantial annual payments to fund the development
and to compensate Corp 2 on an ongoing basis for servicing and maintaining the
exchange. Corp 1, Taxpayer and LLC 1 also agreed to encourage their members to
participate in the exchange.

For their support and commitment, Corp 2 agreed to award shares of Corp 2
stock and penny warrants to purchase Corp 2 stock to Corp 1 and Taxpayer. The
shares and warrants were awarded on --------------------. After the issuance of the
shares, Corp 1 and Taxpayer together owned approximately ------ of Corp 2. The
shares were vested. The warrants (which were soon thereafter exchanged for restricted
shares) vested over a five-year period so long as Corp 1 and Taxpayer met certain
targets for signing up members to use the exchange.

Both the shares and warrants were compensatory in nature. When Taxpayer
received the original vested shares and as the restricted shares of stock vested,
Taxpayer included an amount in taxable income equal to the fair market value of the
shares. Fair market value was determined by reference to the trading value of the
shares on the day the original vested shares were awarded and on the days the
restricted shares vested.

Taxpayer viewed its relationship with Corp 2 as a patronage relationship. In ------
-------, when Taxpayer entered into the arrangement, it adopted an Addendum to its
Patronage Policy which included the following preamble:

“With the rapid development of the Internet, it appears possible, and
perhaps likely, that in the near future the best and most efficient means for
the Participating Patrons of Taxpayer to place orders under the contracts

PLR-136963-14 5

developed by LLC 1 will be over the Internet. It is considered critical to the
fulfillment of the mission of Taxpayer that such a channel of
communication be developed and that it be available to the Participating
Patrons of Taxpayer on fair terms and at a reasonable cost. Taxpayer,
Corp 1 and LLC 1 have considered various alternatives for developing an
Internet platform on their own, and ultimately have determined that it is in
the best interests of their Participating Patrons that the activity be
outsourced to ----------------------------. (“Corp 2”), a business-to-business e-
commerce company.

Acting on behalf of the Participating Patrons, Taxpayer, Corp 1 and LLC 1
have negotiated an arrangement with Corp 2 whereby Corp 2 will develop
and make available to Participating Patrons of Taxpayer and Corp 1 an e-
commerce platform that will allow Patrons to place orders under LLC 1
contracts over the Internet.

As part of these negotiations, Taxpayer and Corp 1 sought to assure that
the e-commerce platform would meet certain performance standards.
Taxpayer and Corp 1 bargained to obtain for their Participating Patrons
favorable terms and conditions for placing orders through that platform.

As a result of these negotiations, upon closing of the Corp 2 transaction,
which is expected to occur during -------, Taxpayer will receive ----------------
shares (the “Shares”) of Corp 2 common stock and a warrant (the
‘Warrant’) to purchase up to ---------------shares (the ‘Warrant Shares’) of
Corp 2 common stock over a period of 5 years provided certain targets are
met for signing up Participating Patrons.”

The patronage policy provided that any income and expense arising from the
arrangement would be treated as patronage income or expense. This included income
that Taxpayer realized upon receipt of the stock and upon vesting of the restricted
stock.

In -------, Corp 2 and LLC 2 agreed to join forces. LLC 2 operated an exchange
that was in many respects similar to the Corp 2 exchange, except that it was open to all.
LLC 2 described its business as follows:

---------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------

PLR-136963-14 6

By ------- a number of other companies had joined LLC 2. Combining with LLC 2’s
exchange appeared to be a preferable alternative to continuing to go it alone with Corp
2.

There were obvious efficiencies to be gained by the combination:

---------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------------------- -----

---------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------

In the combination, most of Taxpayer’s Corp 2 shares were exchanged for a
partnership interest in LLC 2. After the combination, Taxpayer had a --------interest in
LLC 2. LLC 2 entered an outsourcing agreement with Corp 1, Taxpayer and LLC 1 to
provide supply chain management products and services for Corp 1 and Taxpayer
members. With the addition of Corp 1 and Taxpayer as members, the membership of
LLC 2 grew to ----. All of the members were users of the site.

Taxpayer viewed its relationship with LLC 2 as a continuation of its relationship
with Corp 2. Taxpayer updated its patronage policy to provide that income and expense
related to its interest in LLC 2 and any gains or losses from the disposition of that
interest would be treated in the same manner as originally provided for its interest in
Corp 2.

The ------- sale was a logical next step for LLC 2 and its members. LLC 2 was
originally formed at a time no --------------- exchange existed to allow its members to
develop such an exchange. Having developed the exchange to a level where it was
self-sustaining, the members of LLC 2 felt they could step back from ownership and
active control of the exchange. They reached the conclusion that new ownership was
best suited to take the exchange to the next level.

-----------------------, the President and Chief Executive Officer of LLC 2, described
the thinking of the LLC 2 Board in deciding to go forward with the sale as follows:

---------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------

PLR-136963-14 7

---------------------------------------------------------------------------------------------------

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Taxpayer, Corp 1, and LLC 1 plan to continue to use LLC 2.

Since the sale, Taxpayer considered the alternatives for distributing the proceeds
from the sale and handling the tax loss resulting from the sale.

Taxpayer treated the income arising from the receipt of vested shares of Corp 2
stock and from the vesting of shares of restricted stock as patronage-sourced income
and included that income in patronage dividends paid to members ----------------------------
---------------------. Because there was a public market for shares of Corp 2 stock, the
amount of income earned was determined by valuing the shares at the fair market value
at the time of receipt (for the original vested shares) or vesting (for the restricted
shares). Taxpayer planned to hold the Corp 2 stock indefinitely because ownership of
those shares helped cement the relationship between Taxpayer, Corp 1, LLC 1 and
Corp 2.

However, from the start, Taxpayer recognized that this presented a risk. The
Corp 2 business was speculative. That had already been reflected in the performance
of the shares, which had dropped dramatically earlier in the year. There was a real
possibility that the Corp 2 shares could decline further in value, leaving Taxpayer with a
loss. In that event, Taxpayer wanted to be able to trace that loss to the members that
had benefited in the years the Corp 2 shares were originally received or vested.

To lay the groundwork for accomplishing that result, Taxpayer separately
determined the portion of its patronage dividend that was paid out of net earnings
resulting from receipt and vesting of the Corp 2 stock. It then paid the noncash part of
that portion in a separate class of written notices of allocation which it designated in its
records as “special” written notices of allocation. Taxpayer’s patronage policy was
amended in ------- to include the following:

PLR-136963-14 8

“Prior to the time a patronage dividend is paid out of this income [arising
from the receipt of shares of Corp 2 stock], it is anticipated that the Bylaws
of Taxpayer will be amended to create a new class of written notices of
allocation know as Special Written Notices of Allocation for use in such
patronage dividend. It is contemplated that the new class of Special
Written Notices of allocation will be redeemable at the discretion of
Taxpayer not only for cash, but also for Corp 2 shares. In addition, it is
contemplated that the new class of Special Written Notices of Allocation
will not be automatically redeemed over five years upon the departure of a
Participating Patron. In addition, it is contemplated that Taxpayer will be
entitled at the discretion of the Governing Board to offset any capital
losses it may incur for federal income tax purposes pro rata against such
notices….”

The contemplated amendments were, in fact, adopted later in -------. In particular,
Section Article VIII, Section 2(g)(ii) of Taxpayer’s Bylaws was amended to provide:

“(ii) in the event that the Corporation shall incur a loss or losses that are
treated as capital for federal income tax purposes, such notices [the
Special Written Notices of Allocation] may, at the discretion of the
Governing Board, be reduced pro rata by the amount of such loss or
losses either in the year of the loss or thereafter…”

Taxpayer is considering adopting the following plan (the “Plan”) related to the
sale of its interest in LLC 2. First, Taxpayer is considering using the $---------------of sale
proceeds (less related expenses) to redeem a portion of the special written notices of
allocation at their stated dollar amount. Second, Taxpayer is considering exercising the
power granted to it by its Bylaws to offset the approximately $------------------tax loss
triggered by the sale against an equal dollar amount of special written notices of
allocation on a pro rata basis. Third, after these things are done, Taxpayer is
contemplating leaving the remaining special written notices of allocation outstanding
indefinitely.

Based on the foregoing, Taxpayer requests the following rulings:

1. The loss resulting from the sale of Taxpayer’s interest in LLC 2 is properly
   chargeable to members holding special qualified written notices of allocation as
   provided in the Plan.

2. Charging the LLC 2 loss to members as provided in the Plan by cancelling
   special written notices of allocation will have no tax effect to Taxpayer other than the
   reduction of the tax loss incurred by reason of the sale of the interest in LLC 2.

When a cooperative incurs a loss related to patronage activities, it has long been
recognized that a cooperative may charge that loss to members. See, for example,

PLR-136963-14 9

Rev. Rul. 70-407, 1970-2 C.B. 52 (loss charged to members by cancelling written
notices of allocation) and Rev. Rul. 81-103, 1981-1 C.B. 447 (loss charged to members
by offsetting nonqualified written notices of allocation).

The rationale behind allowing cooperatives to pass losses through to members
rests upon the fundamental element of “operating on a cooperative basis,” namely the
principle of “operation at cost.”

Revenue Ruling 69-67, C.B. 1969-1, 142, provides that one of the fundamental
principles associated with a cooperative is that it be operated at cost for its patrons.
This principle is usually evident when the net earnings (net savings) resulting from the
operation of the cooperative from business done with or for its patrons are returned by
the cooperative to its patrons in proportion to the amount of business done with or for
each patron.
A corollary to this cost principle of operation is that any losses of the cooperative
operation attributable to excess advances or undercharges to the patrons are
recoverable from the patrons. This recovery can be made through the cancellation of
outstanding credits that the patron has on account with the cooperative. It can be made
through direct assessment of each patron’s share of the loss, or the cooperative may
set up an account receivable from each patron if it is on the accrual basis. Under any of
these methods the cooperative would in fact have no loss due to excess advances or
undercharges.

Section 1.1382-3(c)(3) of the Income Tax Regulations provides generally that, ‘if
capital gains are realized by the association from the sale or exchange of capital assets
held for a period extending into more than one taxable year income realized from such
gain must be paid, insofar as is practicable, to the persons who were patrons during the
taxable years in which the asset was owned by the association in proportion to the
amount of business done by such patrons during such taxable years. The same general
rule should also apply to capital losses or to any other type of loss which, although
recognized for tax purposes in one year, is really a result of a decrease in value of an
asset which was held for more than one taxable year. Such allocation of gain or loss
need not be done with exactitude. All that is required is an allocation insofar as is
practicable.

Taxpayer believes that the Plan is the fairest treatment of the proceeds and the
loss resulting from the sale of its interest in LLC 2.

As described above, one of Taxpayer’s core activities is to provide products and
services that assist its member -------------- with supply chain optimization. Taxpayer
entered into the relationship with Corp 2 (and later with LLC 2) to help develop an
internet-based tool that members could use for just this purpose. Taxpayer has
consistently treated its relationship with Corp 2 (and later with LLC 2) as a patronage

PLR-136963-14 10

relationship. The resulting losses are patronage-sourced and thus losses of a sort that
can be properly charged to supply chain members.

The approach for handling the loss by charging it pro rata to special written
notices of allocation is the fairest means to apportion responsibility of the loss among
the members of Taxpayer. As described above, the special written notices of allocation
were initially authorized for use in patronage dividends out of income realized when
Taxpayer earned the Corp 2 stock. When those patronage dividends were paid,
Taxpayer was concerned that the value of the Corp 2 stock might later decline leaving
Taxpayer with losses. Taxpayer felt then, and it feels now, that it is fairest to charge
those losses to the members that benefited from the patronage dividends paid out of
income recognized when the Corp 2 stock was received (in the case of the original
vested shares) or became vested (in the case of the restricted shares). Taxpayer
believes that its proposed plan meets the test of reasonableness and practicality in the
approach that it is using to allocate this loss.

The loss which Taxpayer proposes to charge members will be characterized as a
capital loss for tax purposes. From a patronage accounting perspective, there is no
distinction between capital and ordinary losses. The approaches recognized over the
years for fairly charging ordinary patronage losses to members apply equally to
charging capital patronage losses to members.

The approach followed in the Plan follows the approach that was built into
Taxpayer’s patronage policy at the time Taxpayer entered into the arrangement with
Corp 2. While Taxpayer and its members did not know at the time that Taxpayer’s
ownership interest in Corp 2 (or its successor LLC 2) would ultimately generate a loss,
there was concern that could be the case. The special written notices of allocation were
created to provide a means to charge any loss to appropriate members.

Taxpayer’s members were aware of the patronage policy, and the Bylaws were
amended with member approval to authorize the creation of the special written notices
of allocation to implement the plan. Handling the loss in any other manner would upset
the expectations of Taxpayer and its members.

Accordingly, based solely on the law and analysis discussed above, we rule that:

1. The loss resulting from the sale of Taxpayer’s interest in LLC 2 is properly
   chargeable to members holding special qualified written notices of allocation as
   provided in the Plan.

2. Charging the LLC 2 loss to members as provided in the Plan by cancelling
   special written notices of allocation will have no tax effect to Taxpayer other than the
   reduction of the tax loss incurred by reason of the sale of the interest in LLC 2.

PLR-136963-14 11

No opinion is expressed or implied regarding the application of any other
provision in the Code or regulations. This ruling is directed only to the taxpayer that
requested it. Under section 6110(k)(3) of the Code it may not be used or cited as
precedent. In accordance with a power of attorney filed with the request, a copy of the
ruling is being sent to your authorized representative.

Sincerely yours,

Nicole R. Cimino
Senior Technician Reviewer, Branch 5
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)